Auditing of Governmental and Not-for-Profit Organizations

1. 11 Chapter Auditing of Governmental and Not-for-Profit Organizations

2. Learning Objectives After studying Chapter 11, you should be able to: • Explain the essential elements of financial audits by independent CPAs, including: • The objective(s) of financial audits. • The source and content of GAAS. • The types of audit reports than can be rendered. • The contents of an unqualified and a qualified audit report. • Materiality. • GAAP hierarchy. • Required supplementary information.

3. Learning Objectives (Cont’d) • Explain what is meant by GAGAS, the source of GAGAS, why GAGAS are much broader than GAAS. • Explain the types of audits performed under GAGAS, including: • Financial audits. • Attestation engagements. • Performance audits.

4. Learning Objectives (Cont’d) • The characteristics of a single audit, including: • The purpose, • Which entities must have a single audit, • What auditing work is required, • How major programs are selected for audit, • What reports must be rendered, when, and to whom, • Describe the implications of the Sarbanes-Oxley Act of 2002 on governments and not-for-profit organizations.

5. Objectives of a Financial Audit • Render a report by independent auditors expressing an opinion that the financial statements present fairly the financial position, changes in financial position, and, where applicable, cash flows of the organization. • “Present fairly” means in conformity with appropriate generally accepted accounting principles (GAAP) • Opinions are based on reasonable assurance that the statements are free from material misstatements.

6. Generally Accepted Auditing Standards (GAAS) • Auditors performing financial audits follow GAAS, reflected in Statements of Auditing Standards (SASs) issued by the AICPA • 10 standards (expanded on by more than 100 SASs) 3 general standards 3 field work standards 4 reporting standards • See Ill. 11-1

7. Auditor’s Standard Report Paragraphs in a standard audit report: • Opening Identifies the financial statements being audited • Scope Describes the nature of the audit • Opinion Expresses the auditor’s opinion about the fairness of the financial statements • Explanatory Used in most governmental audits, usually related to the auditor’s role in reviewing supplementary information

8. Types of Auditor’s Opinions • Unqualified (clean)—Statements present fairly the financial position and changes in position (and cash flows, if applicable) according to GAAP. See Ill. 11-2 • Qualified opinion—Statements contain a material departure from GAAP or there is a material change between periods in GAAP. See Ill. 11-3 • Adverse opinion—Financial statements do not present fairly in conformity with GAAP • Disclaimer of opinion—Often due to inability to examine records.

9. GAAP Heirarchy—SAS No. 69 and No. 91—Ill. 11-4

10. Materiality • DEFINITION: In the auditor’s judgment, the level at which the quantitative or qualitative effects of misstatements will have a significant impact on users’ evaluations • AICPA Audit and Accounting Guide State and Local Governments requires auditors to make separate materiality determinations for each opinion unit. Under GASBS 34, these are • governmental activities • business-type activities • aggregate discretely presented component units • each major governmental and enterprise fund • the aggregate remaining fund information

11. Auditing Required Supplementary Information (RSI) • RSI, such as MD&A and budgetary comparison schedules, are outside the scope of the financial statement audit • Auditors apply certain limited procedures in connection to RSI to provide assurance that they are fairly presented in relation to the basic financial statements

12. Types of Governmental Audits Ill. 11-5 Financial—An opinion as to whether financial statements are presented fairly in conformity with GAAP and all material facts are disclosed Attestation engagement—Examinations or procedures that lead to a report and assertion about subject matter that is the responsibility of another party, e.g., internal controls, compliance, MD&A, contract amounts, performance measures Performance—A determination of whether managers are using resources efficiently and effectively in accomplishing organizational goals

13. Generally Accepted Government Auditing Standards (GAGAS) • Standards issued by the U.S. Government Accountability Office in its “yellow book” • Required of auditors in a Single Audit of organizations that expend more than $500,000 in federal sources in any year • May be required by states of its local governments

14. The Number of GAGAS Exceeds GAAS Ill. 11-6

15. Unique Aspects of GAGAS • Standard on adequacy of professional proficiency requires auditors to have: • A thorough knowledge of governmental auditing and the specific or unique environment in which the audited entity operates • At least 80 hours of CE (CPE) every two years, of which at least 20 hours must be completed in each of the two years and at least 24 hours of which must be related directly to the audit environment (some technical changes were made in 2005)

16. Unique Aspects of GAGAS (Cont’d) • GAGAS standards place much more emphasis on compliance with laws and regulations than do GAAS

17. Independence Standards • Independence is the cornerstone of the auditing profession and the second general standard in both the AICPA’s GAAS and GAO’s GAGAS • GAGAS’ independence standard was changed in 2002 to address primarily nonaudit work performed for audit clients

18. GAO Independence Standards–Nonaudit Work • DEFINITION: That solely performed for the benefit of the entity requesting the work and does not provide for a basis for conclusions, recommendations, or opinions as would a financial audit, attestation engagement, or performance audit

19. GAO Independence Standards–Nonaudit Work • Two overarching principles: (1) Auditors should not perform management functions or make management decisions (2) Auditors should not audit their own work or provide nonaudit services in situations when the nonaudit services are significant to the audit subject matter

20. GAO Independence Standards Nonaudit Work (Cont’d) • What work is acceptable (no safeguards need to be in place)? Providing routine advice or methodologies, serving on advisory committees, answering technical questions, providing training • What work is prohibited? Maintaining the accounting records, posting transactions to the records, recommending a single person for a position. supervising the information technology system • What work is permitted (if safeguards are in place)? Preparing draft financial statements based on management’s trial balance, maintaining depreciation schedules for which management has determined the key elements in the calculations, proposing adjusting and correction entries that management accepts

21. Safeguards (1) Preclude nonaudit personnel from planning the audit (2) Do not reduce the scope of the audit (3) Document consideration of nonaudit work (4) Document an understanding with the client of the objectives and scope of the audit work (5) Include policies to ensure compliance with independence standards (6) Avoid certain nonaudit work such as operating the client’s accounting system (7) Make all documentation available for peer review

22. What is the Purpose of a Single Audit? • Improve the efficiency and effectiveness of governmental audit effort • Replace a multitude of grant-by-grant audits with a single, comprehensive, entity-wide audit • Provide all federal awarding agencies a single report of a recipient of federal awards to satisfy program’s audit requirements

23. What Entities Must Have a Single Audit? • Those that expend more than $500,000 in federal financial assistance in a year • initially set in 1984 at $100,000 of funds received • amended in 1996 to $300,000 expended • increased in 2005 to $500,000 • State and local governments, not-for-profit organizations, including hospitals. • If expended only for one program or one program cluster, the entity may have a program audit, otherwise the audit must be a single audit

24. Single Audit (Cont’d) 1996 Single Audit Act Amendments: • Establishes a risk-based approach for audit testing, thus placing greater audit coverage on high risk programs • Improves the contents and timeliness of single audit reporting • Permits the Office of Management and Budget (OMB) to administratively revise Single Audit requirements without requiring additional legislation • See OMB Circular A-133 and the related Compliance Supplement for implementation guidance

25. Single Audit (Cont’d) • Calculation of amount of federal awards expended • Calculation can be complex • Basic rule is that a federal award has been expended when the federal agency has become at risk and the nonfederal recipient has a duty of accountability • See Case 11-2

26. Single Audit Requirements • Annual audit encompassing the entity’s financial statements and schedule of expenditures of federal awards • Audit must be conducted by an independent auditor • Auditors must follow GAGAS (yellow book standards) • Auditor must determine whether financial statements present fairly in conformity with GAAP and the schedule of federal financial awards is presented fairly in relation to the financial statements

27. Single Audit Requirements (Cont’d) • Auditor must obtain an understanding of internal controls pertaining to the compliance requirements for each major program, and assess control risk and perform tests of control • Federal and nonfederal “Pass-through” agencies are assigned certain responsibilities for compliance

28. Compliance Audits (as part of single audit) • For each major program the auditor must test whether the program: • was administered in conformity with the appropriate OMB Circular (A-102 or A-110) • complied with detailed requirements in the A-133 Compliance Circular and other specified requirements

29. Selection of Programs for Single Audit Using sliding scale shown in Chapter 11 follow steps in Ill. 11-9 • Identify Type A programs • Identify low-risk programs (based on no audit findings in most recent audit and absence of certain risk factors) • Assess risk of Type B programs (major programs that are not Type A programs)

30. Selection of Programs for Single Audit (Cont’d) • At a minimum, audit all high risk Type A programs and either (1) half of the high-risk Type B programs or (2) one high-risk Type B program for each low-risk Type A program • Audit at least enough major programs to ensure that at least 50% of total federal award expenditures are audited

31. Required Reporting Under Single Audit • Both auditee and auditor have responsibilities for the “reporting package” that must be filed electronically and sent to the single audit clearinghouse • Reporting package consists of: • Financial statements and schedule of expenditures of federal awards • Summary schedule of prior audit findings • Auditor’s reports (see Ill. 11-10) • Corrective action plan

32. Required Reporting Under Single Audit • Schedule of findings and questioned cost • Describes such matters as internal control weaknesses, instances of noncompliance, questioned costs, fraud, and material misrepresentations by the auditee • Internal control weaknesses are reported as either: reportable conditions (significant internal control deficiencies that could adversely affect compliance), or material weaknesses (severe reportable conditions that render internal controls ineffective in reducing risk of noncompliance to an acceptably low level)

33. Schedule of Findings and Questioned Costs (Cont’d) • A questioned cost usually involves an instance of noncompliance with a law or regulation where the costs are either not allowable, are unreasonable, or are not supported by adequate documentation • Known questioned costs greater than $10,000 or likely costs greater than $10,000 must be reported in the schedule of findings and questioned costs

34. Cognizant Agencies • To promote quality control, nonfederal entities expending more than $50 million in federal awards are assigned a cognizant agency—usually the agency providing the predominant amount of support • Cognizant agency provides technical advice and liaison, conducts quality control reviews, refers substandard audits for disciplinary action, and facilitates communication

35. Oversight Agencies • Nonfederal entities expending less than $50 million are assigned an oversight agency rather than a cognizant agency • Oversight agencies have similar but less extensive responsibilities than oversight agencies

36. Implications of Sarbanes-Oxley Act of 2002 on State and Local Governments S-OX applies to publicly-held companies, but many governments are adapting some “best practices” in the areas of: • Audit Committees–subsets of the governing council that appoint, oversee, and work with the external auditor throughout the year • Independence–ensure that auditors are independent especially when nonaudit work is also performed • Internal Controls–OMB Circular A-123 Management’s Responsibility for Internal Control is one example of a review and tightening of internal controls in the government sector

37. Concluding Comments • Auditors add value to information by being independent and conforming to professional auditing standards (GAAS or GAGAS) • GAGAS applies to audits of nonfederal entities that expend at least $500,000 of federal awards • GAGAS are broader than GAAS in that they include standards for financial and performance audits • The single audit improves both the efficiency and effectiveness of audits of nonfederal entities with significant expenditures of federal award END